Widening liquidity deficit in the Indian banking system

GS Paper III

News Excerpt:

RBI addresses the banking system's increased liquidity deficit by injecting ₹2.50 lakh crore via 15-day variable rate repo (VRR) auction.

More details on the news:

  • The Central Bank took this decision as the overall liquidity deficit in the banking system widened to ₹3.34-lakh crore on January 23, 2024 as compared with ₹1.29-lakh crore as on January 1st.
  • In January, the maximum liquidity that the central bank infused was ₹1.75-lakh crore via a 13-day VRR on January 12th.

Liquidity in the banking system

  • Liquidity in the banking system refers to readily available cash that banks need to meet short-term business and financial needs.
  •  Liquidity in the banking system includes VRR auctions, liquidity drawn from the marginal standing facility, surplus funds parked at the standing deposit facility, and liquidity infused by the RBI via various long-term repo operations during the Covid-19 period (2021).
  •  The liquidity deficit means the amount of funds banks need to borrow from the interbank market or from the central bank.
  •  In case of borrowing  from RBI, if the banking system is a net borrower from the RBI under Liquidity Adjustment Facility (LAF), the system liquidity can be said to be in deficit and if the banking system is a net lender to the RBI, the system liquidity can be said to be in surplus.
  • The LAF refers to the RBI’s operations through which it injects or absorbs liquidity into or from the banking system.

 

Variable Repo Rate (VRR)

  • When RBI desires to infuse liquidity in the economy, but Banks are not eager to borrow from RBI at Repo Rates as interest rates in the economy may already be lower, in that case RBI allows Banks to borrow at rates decided by market generally lower than Repo Rate.
  •  In short, the RBI conducts variable rate repo auctions to infuse system liquidity.

 Variable Reverse Repo Rate (VRRR)

  • VRRR is a sub-type of reverse repo. It is kept higher than the reverse repo rate but lower than the repo rate to attract funds from banks.
  • To enjoy the higher rates, banks would attract deposits and to do that, they would offer higher interest rates on deposits. This way, money will go from the depositors to the banks and from the banks to the central bank, thus leading to less liquidity.
  • Outflows due to GST payments and advance tax: Banks are facing pressure on the liquidity front as there were outflows on account of GST payments and advances tax outflows.
  •  Accumulation of cash balances: The central government has accumulated cash balances (estimated at about ₹2-lakh crore) with the RBI, further restricting available liquidity for banks.
  • Intense competition from NBFC: Banks are facing stiff competition from non-banking finance companies for garnering resources.
    • Non-convertible debentures floated by NBFCs are offering relatively higher returns (up to 10%) against Bank term deposit rates of 6.50-7.25 for over a one-year tenor.
  • The surge in equity investment: The surge in retail investment in equity markets, including initial public offerings (IPOs) and mutual funds, contributes to the liquidity challenge for banks.
  • Other reasons: According to the RBI Governor, the overall tightening of liquidity conditions is attributed mainly to higher currency leakage during the festive season and the Reserve Bank’s market operation among other factors.

Currency leakage

  •  It means there is more money with the public and lesser deposits in the bank thereby reducing the amount bank can lend out resulting in lower money supply.
  • Currency leakage impacts the money supply in the economy.

Suggestions to ease liquidity pressure

Sustained tightness in the banking system liquidity could prove to be onerous for borrowers and will worsen in case government spending does not accelerate in a meaningful way. The following are suggestions:

  •  Government Spending of Accumulated Balances: The market players suggest that the liquidity pressure could ease if the government starts spending the balances accumulated with the RBI.
  • RBI Absorption of Foreign Portfolio Investors' Dollars: They also suggest that if the RBI absorbs the dollars that foreign portfolio investors are bringing into the Indian equity market, it could result in an enhancement in liquidity.
  • The monetary policy stance should change to ‘neutral’ from ‘withdrawal of accommodation’ to maintain consistency of stance and action.
  • Neutral stance: The infusion of durable liquidity is becoming necessary, and idealistically, the monetary policy stance should change to ‘neutral’ from ‘withdrawal of accommodation’ to maintain consistency of stance and action
  • Permanent liquidity measures through OMO: Analysts suggest the RBI announce permanent liquidity measures such as open market operations (OMO) purchases to ease liquidity deficit conditions in the banking system rather than variable repo rate auctions (VRR) to infuse temporary liquidity.

Conclusion:

Thus, to address the liquidity challenges, proactive measures by RBI and potential government spending are expected to foster a positive impact, ensuring stability and opportunities for borrowers and investors in the evolving financial landscape.

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